From Know Your Customer and Anti-Money Laundering Perspective: Blockchain and Crypto Currency Regulation


Convertible, decentralized and cryptographic moneys will have an important role in payment systems, as well as it will be a useful tool for illegal structures. Therefore, these currencies create unique ML/FT risks. Although their volumes and effects are relatively low, crime proceeds laundered through crypto-currencies will probably to increase. I would like to focus on AML/CFT frameworks on crypto currencies in this article.

FATF defines that virtual currency is a digital representation of value that can be digitally traded and functions as (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not have legal tender status (i.e., when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction. EC also has adopted a definition deriving from FATF.  According to the definition, even though virtual currencies are not necessarily attached to a legal organization, they are ultimately accepted by natural or legal persons.

As Know Your Customers (KYC) is relatively fresh for Turkish financial institutions, it is vital part of due diligence requirements of AML/CFT. The main target of KYC is to identify customers and beneficial customers of corporations as well as the identification of ML/FT indicators. In an environment where KYC and transaction-monitoring requirements are very crucial, AML and CFT requirements of virtual currencies should also be clarified. KYC and other AML/CFT requirements has been designed for a centralized financial habitat, as opposed to virtual payment systems and their components. Because of their decentralized cross border virtual protocols, it is very difficult to comply with AML/CFT requirements. AML/CFT requirements demand from financial institutions to be gatekeepers, but payment institutions relied on virtual currencies have not any sufficient degree of control over assets.

Even though virtual currencies and related payment systems are the pioneer of the new generation money transmission and payment systems, and expedite microcredit and financial inclusion, the lack of traceability and anonymity of distributed ledgers creates risks with regard to potential illicit uses. Therefore, the envisagement of virtual currencies with KYC and client due diligence is too difficult for financial markets. In the meantime challenging of KYC processes, it is an efficient fiat currency for illicit activities. For instances, offenders can open anonymous or pseudonyms wallets at lower costs for illicit activities or hide source of funds to be transferred across borders. Atomic swaps, unregistered ICO’s are examples of the misuse of virtual currencies.

In fact, traceability does not significant risk while transactions are consisted of single distributed ledger or virtual currency protocol. On the other hand, cross virtual currencies transactions (exchange) cannot be traced if accessing to off-chain records of intermediaries or exchangers is not possible in an environment where unregulated and located in multiple jurisdictions. Also, its decentralized structure precludes law enforcement from targeting, accessing and investigating of customers and transaction records.

Anonymity is main problem of AML. As known, anonymity is the main characteristic of the majority of crypto-currencies such as Bitcoin and Ether etc. Even these currencies conceal user identities, some information about transaction such as dates, values, counterparty’s address are available to public. (There’s more than that Zcash, Dash, Monero are designed fully anonymous)

Unfortunately, any legal and regulatory regime could not have found any unique solution for adoption with global AML discipline. Let alone a legislation, Turkey has still preferred conservative regime for virtual currencies[1]. Around the world, licensing requirements for virtual currency exchangers and wallet services and approaching to ICO’s within the frame of AML are active. Other legislations and regulations in this subject are evolving from day to day. For example, EU with fourth money laundering directive (MLD4) set stringer standards and measures in order to prevent virtual currencies from using EU’s financial system for ML/FT purposes. As well as MLD4’s preventive system bases on the checking the identity of customers, the identification of beneficial ownership and ongoing evaluation and monitoring, virtual currency exchange platforms and custodian wallet providers has been added in the scope of the directive 5 (MLD5). In harmony with FATF requirements, all gatekeepers (as I mentioned shortly before), virtual exchange platforms and wallet within the bounds of crypto to fiat (or fiat to crypto) will be covered by MLD5. (We can conclude that MLD5 leaves crypto to crypto exchanges out of the scope. However, this issue is treated at Member State Level.) Also, MLD5 aims to take entities which provide to safeguard, hold, store and private cryptographic keys on behalf of customers, hold, store and transfer etc. into the score of the regulation. According to the directive, financial institutions should understand the relevant risk, manage risk reasonably and have tools to manage it (policies, procedures, training programs etc.)

As I said, there is not matured approach how to deal with KYC and customer due diligence from a ML/FT risk assessment approach. So, we can adapt previous approaches to virtual currencies and related payment services’ risks. How a new line of business, product or type of customer or transaction have to be evaluated whether understanding related risks, managing them and having the knowledge, tools and resources on an ongoing basis, the eco system of virtual currencies may be subjected to these practices. By all means, requirements should be implemented risk based approach which depends on the type of business, client type and other factors. Otherwise, the institutions cannot ensure a confidence which to allow them to implement. Unless crypto currencies become widely accepted /convertible currencies such as fiat, regulatory pressures continue on these decentralized structure.

In Turkey, Turkish authorities are on the bottom of the ladder, so related virtual currency entities and their ecosystem should understand common/international Know Your Customer standards, procedures and checklist and help to develop a national framework. Virtual currency payment products and services developers, investors etc. should find technology based solution to cover related risks and integrate into existing financial system. They can benefit from FATF’s specific guidance which was issued in 2015. FATF recommends that related entities, which have convertible currency and decentralized system, are have to be exposed to an enchanted due diligence process considering higher risk elements because of their inherent anonymity elements  and difficulties of proper identification. FATF rejects wholesale mentality. It thinks that prohibiting all activities leads to drive underground, so FATF should seek for implement additional mitigation criteria. FATF’s main precaution is that countries ensure that originator and beneficial owner information must be available if virtual currency exchangers transferred value to fiat and it exceeds threshold level (lower risk level can be overlooked)

However, the future of virtual currencies is beyond FATF and it is the agenda of G20. Just a few days ago, G20 agree to regulate crypto assets in line with FATF recommendations (Look at:

FATF advice countries to create Financial Intelligence Units for virtual currencies and related payment services. The cooperation of FIU’s at international level and the development of self-regulation at national level may be efficient and quick measure to address ML/FT issues. Thereby, virtual currency exchangers may adapt their activities with a sound KYC and due diligence framework.

On the other hand, central bank crypto currencies could be an alternative solution to mitigate ML/FT risk because it is estimated that these currencies allow for digital records and traces. Some central banks plan to issue their crypto currencies in order to take advantages of dematerialization of the currency (for lower cost) and execute transfers by avoiding currency issues.

The final solution is a bit technical. Some features of distributed ledgers and protocols enable entities to know its customers. Beneficial owner and other transactional information could be registered on a dedicated distributed ledger (a constant structure that is accessible by gatekeepers and authorities.

[1] The purchase and sale of convertible virtual currency on a commercial basis and the using platforms to transfer money (or to convert money) should be subjected to AML regulations. Obtaining permission from authorities should be mandatory to start activities in Turkey.

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